Weekly Market Report

24 October 2023

Global Report

Middle East conflict.

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Local Report

Why is the JSE experiencing an exodus of companies?

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Market Indicators

Global and local indicators.

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Global Report: Middle East conflict

By Nick Downing

In its bi-annual Financial Stability Report the Federal Reserve highlighted that the Middle East conflict could, together with the Ukraine war deliver “broad adverse spillovers to global markets…. Escalation of these conflicts or a worsening in other geopolitical tensions could reduce economic activity and boost inflation worldwide, particularly in the event of prolonged disruptions to supply chains and interruptions in production.” War tends to be inflationary, especially if it leads to a spike in oil prices. The IMF estimates that a 10% increase in the oil price would raise global inflation by 0.4%. The International Energy Agency has warned that “markets will remain on tenterhooks as the crisis unfolds.”

Before the start of the 1973 Arab Israeli War the oil price was trading below $25 per barrel. After Arab OPEC members cut off oil shipments to the US in retaliation for it supporting Israel, the oil price almost trebled in six months to just under $70 per barrel. US consumer price inflation accelerated from 3.3% in 1972 to 6.2% in 1973 to 11.1% in 1974. Since the Hamas attacks on Israel on 7th October the Brent oil price has gained from $85 to $90 per barrel. The US dollar usually strengthens when conflict erupts but the dollar index has barely moved, in fact has lost ground from 106.04 to 105.60. The US benchmark equity index, the S&P 500 has dropped from 4308 to 4217, a decline of 2.1%. The market response so far has been muted. Financial markets are cold blooded, callous creatures, paying little heed to the terrible human toll.

Financial markets are also barometers. The relatively mild response in currency, equity and oil markets is telling us that the conflict will be restricted to the Gaza strip with only mild skirmishes on the borders with Lebanon and the West Bank. Most Arab states do not support a broader conflict. Under this scenario, the conflict is likely to be short-lived lasting less than 3 months, with little global economic impact, either to production or to inflation. Under what circumstances could economic conditions deteriorate? If the conflict broadens regionally leading to a wider war with Hezbollah and Syria. The worst-case scenario would entail direct warfare between Israel and Iran. Israel may strike Iran’s nuclear facilities out of frustration if it makes slow progress against Hamas. A major conflict with Iran could result in a blockade of the straits of Hormuz, a major chokepoint for seaborne oil transport, potentially leading to a doubling in oil prices akin to the 1973 experience.

Fortunately, indications point to the milder outcome. Threats have been made by Iran and Palestinian sympathisers but there has been no follow-up. Regional neighbours such as Jordan are stable. There is considerable international pressure on Israel to de-escalate the conflict. Other positive signs include the release of some hostages and the safe passage of humanitarian relief convoys. In the worst-case scenario, a sharp increase in the oil price would not be as damaging as in 1973. The oil market has become more globally integrated, lessening the impact of regional embargos. Energy efficiency has improved dramatically. The IMF calculates that a barrel of oil generates 3.5 times more growth than it did 50 years ago. Any increase in the oil price will accelerate the transition to alternative energy sources, many of which were not available or even being considered in 1973.

In the final analysis, wars are not necessarily bad for equity markets. The US recorded its best single year return of 82% in 1915, the year after the outset of World War 1. In his book, “Stocks for the Long Run,” Jeremy Siegel observes the impact of war on markets. Since 1885, the US economy has been at war or on the sidelines of a world war about one-fifth of the time. On average the equity market does equally well whether at peace or at war, but only in nominal terms. Inflation has averaged nearly 6% during wartime and less than 2% during peacetime. War is bad for inflation, which means that although nominal returns tend to be unaffected, real returns are better during peacetime.

Jeremy Siegel states that “World events may shock the market in the short run, but thankfully they have proved unable to dent the long-term returns that have become characteristic of stocks over the long run.” In the first Gulf War of 1990/91, the Dow Jones Industrial index lost 18% between Iraq’s invasion of Kuwait in August 1990 and 11th October. Equity markets surged when the US-led offensive began on 17th January 1991 rising by 18% by the end of February. Markets initially dropped after the 9/11 attack on the US but between 21st September 2001 and 28th December of that year, the Dow Jones increased by 26% in just 3 months.

Conflict can create opportunity for investors, willing to use any short-term sell-off as a chance to increase holdings in preferred segments of the market. However, the current conflict coincides with other, more significant threats to the short-term outlook for financial markets, notably rising interest rates. Elevated central bank interest rates and elevated bond yields lift the cost of capital and the required return from equity markets, placing pressure on share prices. The reason interest rates are elevated is due to high inflation. Inflation has been exacerbated by consecutive supply shocks, first the Covid pandemic and then the Ukraine war. Although the Middle East War shows signs of remaining contained, it has the potential of creating a third supply shock.

Local Report: Why is the JSE experiencing an exodus of companies?

By Gielie Fourie

INTRODUCTION: Why is the JSE experiencing an exodus of companies? The number of companies listed on the Johannesburg Stock Exchange (JSE) dropped from 600 to 294 over the past 22 years. To put it into context, over 22 years an average of 13 companies left the JSE every year, one company every month, and the tempo is picking up. Over the last eight years an average of 15 companies delisted every year. In the 2022 calendar year 27 companies delisted while there were only 10 new listings. Smaller companies simply delist for various reasons, while bigger companies are acquired by big global companies. Yesterday Textainer announced that it will delist after being acquired by a bigger company.

Net foreign selling of shares on the JSE year-to date (YTD) already amounts to R123 billion (bn) – the total for 2022 was R92bn. The arrival of competition from smaller stock exchanges, like A2X, has attracted listings for smaller companies as well as secondary listings for big JSE listed companies, taking business away from the JSE. With the changes to Regulation 28 for pension funds, institutional investors are now able to acquire 45% of equities outside of SA, and from press reports most have taken up, or are close to the 45% maximum allowance. These changes were the forerunners of several unexpected consequences. Investors invest their proceeds in more attractive investments elsewhere. In many cases the capital flows out of South Africa and will never flow back to the JSE.

EXITING SOUTH AFRICA: Some of our best companies have been acquired by offshore investors. Examples are Clover, taken over by an Israeli company for R4.8bn in 2019, Consol Glass was taken over by a Luxembourg-based glass company in 2021 for R10.1bn, and in 2023 Dutch brewing company Heineken bought Distell for R40.1bn. The biggest take-over was in 2016 when AB InBev bought SA Breweries for $107bn to form the world’s largest beer company. In March 2023, the Competition Tribunal approved the acquisition of Mediclinic by a consortium comprising its shareholder Remgro and Switzerland’s Mediterranean Shipping Company (MSC). The purchase price was $4.49bn. Finally, two weeks ago, on Friday 13 October, Steinhoff was liquidated and delisted. Brendon Hubbard an analyst at ClucasGray commented: “Every single listing that has left South Africa for foreign shores has significantly outperformed.”

COUNTRY RISK: In August, there was sustained and substantial selling of three JSE shares, MultiChoice, Mr Price (MRP) and TFG (Foschini), due to a rebalancing of the MSCI Emerging Markets Index. These three stocks were removed from the index due to South Africa’s weighting in it being reduced. There was nothing wrong with the companies – MSCI regarded South Africa as a country risk. One estimate put the outflow due to this selling at around R7 billion. The three companies were victims of their own success. Their shares were so popular with foreigners that foreigners owned, in the case of MRP, more than 50% of its shares.

LOW ECONOMIC GROWTH: With a constrained energy supply for the next (roughly) 24 months, there is little impetus for real growth. The South African Reserve Bank sees GDP increasing by 1% next year and 1.1% in 2025. South African debt is rated as junk by the three big ratings agencies, and the Financial Action Task Force (FATF) has placed South Africa on its grey list. But there is light at the end of the tunnel. The International Monetary Fund (IMF) has raised slightly its growth outlook for South Africa to 0.9% this year, up from its earlier estimate of 0.6%. IMF forecasts show South Africa is set to overtake Nigeria and Egypt as the continent’s largest economy next year (2024). The JSE is still the biggest stock exchange in Africa with a market capitalisation of $1.36 trillion.

A SMALLER JSE HAS CONSEQUENCES FOR INVESTORS: A shrinking JSE causes the investable universe of shares on the JSE to get smaller and smaller. Analysts argue that as the investable pool of shares shrinks, the valuations of companies drop as companies start trading at discounts to their net asset values (NAVs). Blue chip shares like banks and miners are now trading at single digit Price: Earnings (P:E) ratios. Before 2020 they used to trade at double digit P:E ratios. The P:E ratios of our big four banks are: Standard Bank 7.79x, First Rand 9.15x, Absa 6.94x and Nedbank 6.55x. The exception is Capitec, said to be the most expensive bank in the world, which is trading at a P:E ratio of 20x. Amongst the miners Anglos is trading at a P:E ratio of 7.98x and Glencore at 6.02x. When the benefits of being listed are lost, significantly when it makes little sense to raise equity capital at levels that are so unattractive to the listed company, delisting becomes an attractive option. The companies also become attractive takeover targets for international investors. Taking over a company with a lower P:E ratio than your own P:E ratio is a winning strategy.

Sources: Profile Data, IMF, News24

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Reference: Capital Economics – Historical bond and equity return data.

The Bottom Line: Innovation and the Magic of Compounding

By Carel La Cock

The oldest investment trust listed on the London Stock Exchange can trace its beginnings back to the surging demand for rubber at the advent of the car industry. Following the Panic of 1907 when the New York Stock Exchange fell nearly 50% from its peak, credit markets dried up and realising the opportunity to lend to rubber plantations in Asia, Colonel Augustus Baillie and Carlyle Gifford established The Straits Mortgage and Trust Company Limited that would ultimately become the behemoth: Scottish Mortgage Investment Trust (SMT), a constituent of the FTSE100.

Baillie Gifford & Co, the investment management company that stewards SMT, oversee total assets in the fund of £16.67bn as at the end of February 2022. Outgoing manager, James Anderson, defined his career with early investments in Amazon and Tesla, which propelled the fund to cumulative growth of 696.8% in the last 10-years, compared to 220.4% for its benchmark, the FTSE All-World Index. Anderson’s investment philosophy has always been based on the belief that technological improvements will drive innovation and that even picking a small number of these successful future companies and holding on to them long enough to let the magic of compounding work, will lead to exceptional returns for clients. Tom Slater, co-manager since 2015, will take over the reins at the end of April and believes that it matters less failing to sell the holdings you should sell, than selling the holdings you should not sell. When they go long on investments, they remain long offering support as patient investors often nurturing private holdings until they go public.

After a stellar performance in 2020 which saw net asset value (NAV) grow by 106.5%, 2021 was more subdued by its own standards, up only 13.2%. This year the share price has come under severe pressure from rising inflation and the rising interest rate used in discounting long duration income flows on many of the growth stocks in its portfolio. Moderna, the manufacturer of Covid-19 vaccines and the largest holding in the portfolio at 8% is down nearly a third year to date, while Tencent, the Chinese e-commerce giant, at 4% of the portfolio is down nearly a fifth this year. Others in the top five holdings: ASML (-13%), Illumina (-9.6%), Tesla (-13%) and NVIDIA (-10.4%) have all been downgraded due to expectations of a steepening yield curve.

Is now the time to panic and if not now, then when? Geopolitical risk is at an all-time high, the US federal reserve has just hiked interest rates for the first time since 2018 and global inflation is running rampant while oil and gas prices have spike on supply fears. However, listening to manager, Tom Slater and deputy manager, Lawrence Burns discuss the current environment and the outlook for the portfolio in a recent investor presentation, you don’t get the sense that now is the time to panic, or indeed ever. Their strategy is long-term, and they have positioned the fund to participate in structural changes and technological advances in society. They have incredible deal flow built on decades of strong relationships and a reputation for stability and patience. Entrepreneurs are keeping companies private for longer and having early access to investment in these opportunities often leads to extraordinary returns.

As for its current top holding, asked if Moderna is a “one-trick-pony” with reference to the major windfall from the Covid19 vaccine, but recently downgraded as investors see the end of the pandemic and the Covid-19 vaccine franchise, Lawrence answered “Moderna is a one trick pony, but that one trick is a broad and important one and that trick is mRNA.” The biotechnology behind the Covid-19 vaccine is a powerful one with programmes to cure zika, HIV, cancer and a range of other ailments making the recent windfall unlikely to be a once-off.

Regarding the tightening of regulation in the Chinese technology sector and its impact on Tencent, the team thinks that the Chinese government is ahead of the curve in terms of regulation and that democratic western nations will eventually implement similar regulatory changes. They believe that companies that “go with the grain of society” and who are aware of their broader impact on society will find it easier to prosper. In this regard, Chinese tech companies are further along the route of enlightenment.

Lastly, Tom Slater does not agree that higher inflation and rising interest rates should lead to lower valuations on growth stocks. He cautions investors to also consider the impact of pricing power on some of these high growth companies as they become market leaders in their field. Therefore, with higher expected future inflation, one should also adjust the future cash flows that will yield a better current valuation. Looking past the current volatility, the fund has invested in some ground-breaking technology and the managers are excited by the intersection of computing power and biology calling the opportunity set “large and varied” They have 49 investments in private companies, and it is not difficult to imagine the next Amazon and Tesla coming from that pool.

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